Lessons for policy

SummaryIn the last decade, purely financial players with no interest in the physical commodity, such as hedge funds, pension funds, insurance companies and retail investors, have become more prominent in oil futures and derivatives markets.

Bassam Fattouh & Lavan Mahadeva

In the last decade, purely financial players with no interest in the physical commodity, such as hedge funds, pension funds, insurance companies and retail investors, have become more prominent in oil futures and derivatives markets. In parallel, there has been an explosion in the variety of instruments that permit speculation in oil, such as futures, options, index funds, and exchange-traded funds. This massive expansion of the financial layer of oil has been called the financialisation of the oil markets. Has this affected the price of oil? And does it matter?

Figure 1 plots one measure of financialisation. The net long positions of non-commercial traders in oil futures as compiled by the Commodity and Futures Trading Commission have increased tremendously, especially since 2003. Also, although the data is noisy, a brief slowdown in the second half of 2008 is discernible. The chart shows that the real West Texas Intermediate oil price has followed a similar pattern; it has also risen on average since 2003, and also experienced a temporary fall in late 2008.

Motivated by correspondences of this type, some have concluded that greater financial participation has changed oil-price behaviour (Masters 2008). There have even been calls for policy intervention to limit financial participation in oil per se (UNCTAD 2012). However, as Scott Irwin pointed out early on in this debate, correlation is not causation (Irwin 2008). Indeed, the familiar culprits of supply and demand forces could have been responsible for the post 2003 data on oil prices and financial participation (Fattouh et al. 2012 and Kilian, 2012).

The first conceptual hurdle to overcome is to define what is meant by speculation and financialisation. A typical approach to answer this question is to define destabilising speculation as whatever is left over after fundamental forces have been accounted for (Lombardi and Van Robays 2011).

But speculation is the economic response mechanism to a large variety of underlying uncertain changes, some of which could be down to current and/or anticipated demand and supply prospects and some of which could be down to financial layer shifts. Anyone who decides between buying a small car or a petrol guzzler is effectively speculating in oil, and it is surely not a concern that they have a view on the future price of energy. Similarly, the accumulation of physical inventory in anticipation of future changes (providing the market is not being squeezed) is a market solution to uncertainty.

Thus, as Parsons (2009) explains, we have to be humble about our ability to capture destabilising speculation as what is left over, using the patchy data that we have on oil fundamentals. Similarly, it should also be hard to try and pick the destabilising rise in financial participation from that which is a healthy consequence of secular trends in financial globalisation and financial innovation. Another route is to ask if more underlying changes, such the greater appetites or resources of purely financial investors, can be damaging for final consumers. This is a complementary strategy to an empirical approach. As the Confucian analect goes, “Learning without thought is labour lost; thought without learning perilous” (Legge 1893).

In a recent paper (Fattouh and Mahadeva 2012), we built a small model of the oil market where financial speculators’ risk aversion and wealth are exogenous. We calibrate it to match the pre-2003 data and ask if, as a result of a fall in the risk aversion of financial speculators or a rise in the financial resources they can muster, we can expect a greater participation by purely financial investors and a higher oil price level.

The sizes of these shifts are considerable. We lower the risk appetite of financial players halfway towards making them completely indifferent to risk and raise their wealth by a considerable 25%. A control is provided by shifts in the physical layer of the oil market, such as a sudden expectation of a 5% more expansive net supply as could have occurred in 2006-8.

Figure 2 describes one of our results. Even large changes in financial players’ incentives— shown in the first two sets of columns — are not predicted, by themselves, to have led to more than a small rise in financial player’s futures positions. And they are predicted to imply only small rises in the current spot level.

On the other hand, as the right-hand side of Figure 2 shows, an expected 5% loosening of net supply leads to a large fall in financial participation. This suggests that the fall in participation in 2008 may have been the result of an anticipation of slack in spot oil. Conversely when there is an expected tightening of future supply, inventories will be accumulated and this will stimulate greater need for the hedging services of purely financial players. We should expect a rise in financialisation during these episodes. The implication is that financial participation and oil prices could both be due to anticipations of supply and demand changes, and are not necessarily driven by the incentives of financial players.

Moreover, comparing the vertical and horizontal striped bars, financialisation is predicted to have lowered expected future prices even if it raised current prices. This latter finding is, we argue, a quite general feature of financial layer changes. Incentives to financial players do not affect spot supply and demand directly; financial layer changes only alter how much inventory will be carried over from current to future spot markets. Thus if any change in the financial layer leads to more inventory accumulation, it will indeed raise current spot prices, but then also lower expected prices. If it leads to fewer inventories, then current prices will fall as expected prices rise. Either way, the consequence of financialisation shifts for final consumers who buy spot oil now and in the future will be limited as the current and expected future spot prices will only move in opposite directions and of a very similar magnitude. Because it can have only a seesaw effect on the term structure of prices, it would take an implausibly huge change in financialisation in order to lead to the large change in the level of spot prices we have observed.

In conclusion, these findings (and others in the paper) act as a warning to inferring that greater financialisation has caused higher oil prices on the basis of relationships such as in Figure 1. Theory predicts powerful natural limits on the ability of financialisation shifts to raise spot prices in frictionless markets. In contrast, anticipations of net supply shifts can have important impacts on prices, spreads, welfare, and even on financial market participation.

It is true, however, that many of the theory-based papers on this type of question do not model frictions displayed in real-world financial markets. For example, financial speculators in Fattouh and Mahadeva (2012) are not leveraged and there is no moral hazard in their risk taking. It is quite possible that financial layer changes might be predicted to have large effects under other circumstances.

But even if these fundamental market failures were crucial in establishing an important effect of financialisation, they would elicit their own specific policy solutions. For example, if it were found that the entrance of highly leveraged financial speculators disrupts oil markets, the implication is that prudential regulation should be employed on leveraged investors. Therefore, before oil financial market policies are contemplated, it is crucial in the first instance to identify the channels through which financialisation can result in market failure.